Welcome To Phase Three Of The Global Financial Crisis

It's deliciously ironic that emerging market (EM) problems have flared so soon after the meeting of the rich and powerful in Davos. According to the central bankers at Davos, the financial crisis is behind us and brighter days lay ahead. According to these bankers, the EM issues which have since arisen are confined to a handful of developing countries and they won't impact the West.

If only were that so. What the eruptions of the past week really show is that the system based on easy money created by these bankers remains deeply flawed and these flaws have been exposed by moves to tighten liquidity in the U.S. and China. The system broke down in 2008, and again in Europe in 2011 and now in EM in 2013-2014.

The market reaction to the latest events has been abrupt and violent, particularly in the currency world. In my experience, markets generally cope well when there is one crisis. If the current issue was isolated to Turkey, markets outside of this country would probably shrug their shoulders and move on. But when there are multiple spot fires like the last week, markets don't cope as well.

What are investors supposed to do now? Well, going into this year, Asia Confidential suggested (here, here and here) being cautious on stocks given increasing deflationary risks from U.S. tapering and a China slowdown. And to go long government bonds in developed markets (the U.S) given these risks and junior gold miners due to the extraordinarily cheap valuations on offer. These recommendations have performed well year-to-date and should continue to out-perform for the remainder of 2014.

Simple explanations for the crisis

Much ink has been spilled (or keyboards worn, in this day and age) trying to make sense of the past week's event. China's economic slowdown has copped much of the blame. As has QE tapering. And idiosyncratic issues in Turkey and Argentina have received their fair share of attention.

There have also been more sophisticated explanations such as this one from Kit Juckes at Societe Generale:

"There has been a shift in the balance of growth as Chinese demand for raw material wanes, and as higher wages and strong currencies make many EM economies less competitive. Meanwhile, the Fed policy cycle IS turning, and 4 years of capital being pushed out in a quest for less derisory yields, are ending. This isn't a repeat of the 1990s Asian crises, because domestic conditions are completely different but it is a turn in the global market cycle. We need to transition from a world where investment is pushed out of the US/Europe/Japan to one where it is pulled in by attractive prospects. When that happens, flows will be differentiated much more from one country (EM or otherwise) to another. But for now, we're just waiting for global capital flows to calm down."

Now I have a large issue with the purported attractive prospects of the US, Europe and Japan, but let's put that aside. The bigger issue is that the explanation here appears to be addressing the symptoms of the crisis (global capital flows) rather than the disease (excess credit and an unstable global economic system).

A more nuanced view

Let me elaborate on this. In a previous post, I echoed the thoughts of India's new central bank chief in suggesting that there were four main causes for the 2008 financial crisis:

Rising inequality and the push for housing credit in the U.S.. Growing income inequality in America, exacerbated by technology replacing low-wage jobs and an inadequate education system which failed to re-skill people, led to politicians allowing easier credit conditions to boost asset prices and make people feel wealthier. That resulted in the subprime and housing crisis.

Export-led growth and dependency of several countries including China, Japan and Germany. The debt-fueled consumption in the U.S. would have been inflationary were it not for these countries not meeting the consumption needs of Americans. In other words, they aided and abetted the consumption binge in the U.S.

A clash of cultures between developed and developing countries. This relates back to 1997 when the Asian crisis force countries in the region to go from being net importers to substantial net exporters, thereby creating the conditions for a global glut in goods.

U.S central bank policy pandering to political considerations by focusing on jobs and inflation at any cost. The bank acted in accordance with the wishes of politicians by keeping interest rates too low for too long. They did this to maintain high employment, one of the bank's two central mandates.

It's important to note that none of these issues has been resolved. In fact, many of them have worsened. And any hint of adjustments to one or more of these problems results in further crises (like Europe in 2011 and in EM mid-last year and today).

This isn't to excuse the governance issues in the likes of Argentina and Turkey. But it is to suggest that they are merely symptoms of a deeper malaise.

Deflation is winning battle over inflation

If these adjustments were to happen in full, it would result in plunging global asset prices as excessive debt loads are unwound. De-leveraging, in economic terms. This deflationary action is anathema to the world's central bankers as deflation is enemy number one. Hence, they'll do "whatever it takes" to produce inflation. And if that means flushing currencies down the urinal, so be it. The battle between inflation and deflation is ongoing, though the latter has the upper hand right now.

The weapons of choice for central bankers to fight off deflation are QE and zero interest rates. Central bankers tell us that these policies are necessary for economies to heal. I'd suggest this is baloney and they're exacerbating the aforementioned problems.

To see why, it's important to understand that interest rates are the central price signal off which all assets are priced. If central banks keep rates artificially low, it distorts these asset prices. And if you keep rates low for long enough, it distorts prices to such an extent that it's impossible to know what the real value of certain assets are.

Another issue is that by keeping rates low, businesses which should go bankrupt stay alive. That's why government bail-outs of almost any private company are a bad idea. Keeping zombies businesses alive means economies become less competitive over time. Witness Japan since 1990.

These are but a few of the unintended consequences of the current policies.

The endgame

There are three possible endgames to the current situation:

There's a global deflationary shock where all asset prices fall and fall hard. A la 2008. In this instance, central banks would go in all guns blazing with more money printing on an even grander scale. This would risk inflation if not hyperinflation as faith in currencies is diminished, if not lost.

You have a gradual global recovery and inflation stays tame enough for a smooth exit from current policies.

There's a recovery but central banks are slow to raise rates and inflation gallops, which forces tightening and a subsequent economic slowdown.

My bet remains on the first scenario given intensifying deflationary forces from a China economic slowdown and Japan currency debasement (which aids exporters in being more price competitive).

If I'm right, there may be deflation followed by extreme inflation (or one quickly followed by the other). That makes investing a tough game. Under both of those scenarios, stocks and bonds would under-perform in a big way (my current call to own developed market government bonds is a 6-12 month one, not long-term). That's why cash (which would out-perform in deflation), gold (which would prosper under extreme inflation) and select property and other tangible assets such as agriculture (which may out-perform under extreme inflation on a relative rather than absolute basis) should be part of any diverse investment portfolio.

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"If I'm right, there may be deflation followed by extreme inflation (or one quickly followed by the other)."

STATREGIC INVESTMENT did a 400 year study on inflation and deflation over a 400 year time span in England, the Colonies and America. They found inflation occurs about 50% of the time and deflation occurs about 50% of the time. And once either starts, there are powerful forces which cause the trend to persist.

To see why, it's important to understand that interest rates are the central price signal off which all assets are priced. If central banks keep rates artificially low, it distorts these asset prices. And if you keep rates low for long enough, it distorts prices to such an extent that it's impossible to know what the real value of certain assets are.

This is a twisted half truth. Zero interest rate is akin to non-interest bearing currency. There are other ways to price assets. The amount of manhours required per ounce of gold extracted from the mine plus cost of equipment, and so forth.

You have to look at the types of "loans" the banking cartel is involved in too. Like Credit Card and Student Loan debts. It is a real travesty that the American people allow the corporate-state to bail out trillions for the banking Cartel, but make laws that force a debtor of student loans to never get out from under that albatross. And making matters worse, the student's loan actually increases over time even if he is paying on it, because of outrageous interest. On top of this the young and everyone are being FORCED to buy healthcare or pay a penalty.

There is 3 things that can be done TODAY to make things better for the American economy, at least. One, make it allowable for some or all of student debt to be erased with bankruptcy or other plans. Two, make new regulations on Credit Cards, requiring some form of collateral AND requiring the banks to have a reserve for this. Too many banks are flooding consumers with credit card offers that are merely helping the banks create money out of nothing by way of debt. Three, Under water homes should be automatically reset to the market value.

This would help main street but the banking cartel would literally have to be restructured in order for it to happen. They don't want that to happen because they would lose their power. So, we need to force the government (which should be for the people and of the people) to reign in the financial sector.

There was a case of a girl who had a scholarship. Her friends encouraged her to play on the school softball team. She devoted more time to softball and less time to study. She lost her scholarship. She took out a student loan. She can not repay the student loan.

This case shows that people need to THINK before taking out a student loan. They are better off working their way through school and not borrowing any money, even if it takes many years to complete the education.

Deflationary shock for all assets while prices for consumer goods skyrocket. The scenario no one seems to think can exist at the same time, but would be the ultimate hell for mankind which makes it all the more likely to happen. Our governments. policy makers and bankers are fucking up so much this would be the natural and only outcome.,

"There's a global deflationary shock where all asset prices fall and fall hard. A la 2008. In this instance, central banks would go in all guns blazing with more money printing on an even grander scale."

If it didn't work the first time, why should it work on a grander scale? They are looking for an even grander deflationary shock?

No. Credit/debt money created with interest attached is the cause. The repeal of Glass-Steagall was merely the tool used to allow the leveraging to continue without QE, but the horse was out of the barn. It's all about expanding debt in the aggregate. The system only cares about that... not the source.

It really doesn't matter and the "flation" debate remains largely a waste of time. Simply put, it takes energy and resources to maintain a certain quality of life and to actually do or create anything of real value, period. There are now 7+ billion (and growing, not declining) all competing for consumable energy and resources, the laws of Nature and physics are what they are folks.

"When money start to spread in the society "above acceptable limits", we create financial crises to take them back. We dictate governments to take measures and apply austerity policies directing money back to us. We keep money valuable to everyone and secure our profits."

To me seeing the Davos cabal humiliated is the inevitabliity of hubristic shame; but the pain for millions around the world will outflame the shame if there is no blame to be pegged on those who are the infamous twelvers (or whatever the number be).

Dirty dozens of Oligarchy bamboozling scions deserving the choice between the plank or the lampost yank.

I don't think the Federal Reserve has the legal authority to produce extreme inflation all by itself. It is pretty much out of tools right now, and QE is not inflationary as it has been practiced in the US. However, in the age of lawless Obama, I wouldn't put it past them to do outright illegal things to get inflation at any cost.

"...Federal Reserve has the legal authority to produce extreme inflation all by itself."

Both the FRB and income tax are illegal. Neither was ratified by the States. Both were rammed through congress on the last day before Christmas recess at the end of the day with only three congressmen present.

You forgot the income part of your analysis - central banks enforcing ZIRP means that savers (prudent people, the elderly, insurance cos, pension funds) get punished AND owners of capital get punished; the only ones who win, temporarily, are the debtors who can use larger leverage with less consequence (governments, the imprudent, investment depts of banks).

At some point, the ZIRP policy kills off the savers/pensions/insurance cos amd amy increase thereby in interest rates kills the imprudent.

So you might say ZIRP is a serial murderer, and it's only a matter of time before all in its realm are dead.

You (not TPTB of course) have to pay your bills/debts, so you sell assets during a crash. When everything is leveraged infinitely, everything gets sold infinitely during the crash. There is no safe haven during the crash, because everything has been inflated due to leverage. That being said, there will be items that are oversold during the crash (gold, silver, etc). The problem is you may not have anything of value left during the crash to pay for those things. Stock up now, and watch it dip. Attempt to stock up later, and probably not be able to buy any.